Rate hold by MPC is justified by a confluence of risk

Analysts have formed a broad consensus that the Monetary Policy Committee (MPC) will hold the repo rate at 6 per cent at the December meeting. Despite some significant positive developments since the last meeting – a sharp climb in India’s Ease of Doing Business ranking, public sector bank recapitalisation and Moody’s sovereign ratings upgrade – there seem enough risks in the global and domestic economic environment to keep the repo rate on hold for now.

Juxtaposed against the MPC’s mandate to guide CPI-based inflation to the medium-term target of 4 per cent, we expect a gradual rise in the baseline trajectory to over 5 per cent by mid-2017, but largely due to the predominantly notional HRAs progressively diffusing from states’ implementation of the 7th Pay Commission recommendations. MPC members have indicated that, provided spillovers into the private rental markets are limited, they will “look through” these rises.

There are more substantive concerns on inflation. The current spike in vegetable prices is likely to be transient, but consumer inflation expectations have remained sticky at high levels. Risks to inflation from global factors persist. The drivers of the recent sharp rise in oil and metals prices need to be better understood. The US Federal Reserve is almost certain to raise policy interest rate at its mid-December meeting. The markets still don’t believe the Fed signalling three more hikes in 2018, and, with unemployment levels at almost historic lows and wages beginning to creep up, this sets the stage for potential volatility if economic conditions tighten. Squeezing the rate differential in this environment will pressure the rupee.

In addition, India’s Current Account Deficit (CAD) might worsen – mainly due to higher oil and commodities imports – exacerbating these pressures. Over a longer time horizon, political uncertainty and fiscal tightening in West Asia will have an adverse impact on inbound remittances, further squeezing the CAD.

On the fiscal side, there is increased uncertainty about tax revenue collections, input tax credits due for refunds, tax assessee coverage and payments, transfers to states and multiple other GST related operational issues. The proximate effects on economic activity remain inadequately understood, although yesterday’s Q2 FY18 GDP print of 6.1 per cent indicates a shallow bottoming out of the supply shocks driven slowdown.

The MPC’s stance is unlikely to be tightened, but the tone of the statement might be a bit more hawkish. If tax revenues stabilise over the next couple of months, there might be room for some further shallow easing over the coming months, but the current uncertain economic conditions warrant caution in monetary policy.
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